Read Security Analysis : Sixth Edition, Foreword by Warren Buffett: Additional Aspects of Security Analysis. Discrepencies Between Price and Value for Free Online
Authors: David L. Dodd
share, or more than one-third the amount paid over by the public.
The company had been in business since 1928 and had been manufacturing its light Aeronca planes since 1931. Its business had grown steadily from $124,000 sales in 1934 to about $850,000 sales in 1939.However, the enterprise had been definitely unprofitable to the end of 1938, showing an aggregate deficit at that time of over $500,000 (including development expense written off). In 9½ months to October 15, 1939, it had earned $50,000. Prior to this offering of new shares to the public there were outstanding 66,000 shares of stock, which had a net asset value of only $1.28 per share. In addition to the warrants for 30,000 shares to be given the underwriters, there were like warrants for 15,000 shares in the hands of the officers.
There seemed strong reason to believe that the company occupied a favorable position in a growing industry. But analysis would show that the participation of the public in any future increase in earnings was seriously diluted in three different ways: by the cash selling expense subtracted from the price to be paid for the new stock, by the small tangible assets contributed by the original owners for their stock interest and by the warrants which would siphon off part of any increased value. To show the effect of this dilution, let us assume that the company proves so successful that its fair value is twice its tangible assets after completion of this financing—say, about $1,000,000 as compared with $484,000 of tangible assets. What could then be the value of the stock for which the public paid $6.25? If there were no warrants outstanding, this value would be about $8 per share on 126,000 shares. But allowing for a value of say $2.00 per share for the warrants, the stock itself would be worth only $7.25 per share. Hence even a very substantial degree of success on the part of this enterprise would add a mere 16% to the value of the public’s purchase. Should things go the other way, a very large part of the investment would soon be dissipated.
Should the Public Finance New Ventures? Fairly complete observation of new-enterprise financing registered with the S.E.C. since 1933 has given us a pessimistic opinion as to its soundness and its economic value to the nation. The venturing of capital into new businesses is essential to American progress, but no substantial contribution to the upbuilding of the country has ever been made by new ventures
publicly
financed. Wall Street has always realized that the capital for such undertakings should properly be supplied on a private and personal basis—by the organizers themselves or people close to them. Hence the sale of shares in new businesses has never been a truly reputable pursuit, and the leading banking houses will not engage in it. The less fastidious channelsthrough which such financing is done exact so high an over-all selling cost—to
the public—
that the chance of success of the new enterprise, small enough at best, is thereby greatly diminished.
It is our considered view that the nation’s interest would be served by amending the Securities Act so as to prohibit the public offering of securities of new and definitely unseasoned ventures. It would not be easy to define precisely the criteria of “seasoning,”—
e.g.
, size, number of years’ operation without loss—and it may be necessary to vest some discretion on this score with the S.E.C. We think, however, that borderline and difficult cases will be relatively few in number (although our second example above belongs, perhaps, in this category). We should be glad to see the powers and duties of the S.E.C. diminished in many details of minor significance; but on this point of protecting a public incapable of protecting itself, our view leans strongly towards more drastic legislation.
Blue-sky Promotions. In the “good old days” fraudulent stock promoters relied so largely upon high pressure salesmanship that they
The company had been in business since 1928 and had been manufacturing its light Aeronca planes since 1931. Its business had grown steadily from $124,000 sales in 1934 to about $850,000 sales in 1939.However, the enterprise had been definitely unprofitable to the end of 1938, showing an aggregate deficit at that time of over $500,000 (including development expense written off). In 9½ months to October 15, 1939, it had earned $50,000. Prior to this offering of new shares to the public there were outstanding 66,000 shares of stock, which had a net asset value of only $1.28 per share. In addition to the warrants for 30,000 shares to be given the underwriters, there were like warrants for 15,000 shares in the hands of the officers.
There seemed strong reason to believe that the company occupied a favorable position in a growing industry. But analysis would show that the participation of the public in any future increase in earnings was seriously diluted in three different ways: by the cash selling expense subtracted from the price to be paid for the new stock, by the small tangible assets contributed by the original owners for their stock interest and by the warrants which would siphon off part of any increased value. To show the effect of this dilution, let us assume that the company proves so successful that its fair value is twice its tangible assets after completion of this financing—say, about $1,000,000 as compared with $484,000 of tangible assets. What could then be the value of the stock for which the public paid $6.25? If there were no warrants outstanding, this value would be about $8 per share on 126,000 shares. But allowing for a value of say $2.00 per share for the warrants, the stock itself would be worth only $7.25 per share. Hence even a very substantial degree of success on the part of this enterprise would add a mere 16% to the value of the public’s purchase. Should things go the other way, a very large part of the investment would soon be dissipated.
Should the Public Finance New Ventures? Fairly complete observation of new-enterprise financing registered with the S.E.C. since 1933 has given us a pessimistic opinion as to its soundness and its economic value to the nation. The venturing of capital into new businesses is essential to American progress, but no substantial contribution to the upbuilding of the country has ever been made by new ventures
publicly
financed. Wall Street has always realized that the capital for such undertakings should properly be supplied on a private and personal basis—by the organizers themselves or people close to them. Hence the sale of shares in new businesses has never been a truly reputable pursuit, and the leading banking houses will not engage in it. The less fastidious channelsthrough which such financing is done exact so high an over-all selling cost—to
the public—
that the chance of success of the new enterprise, small enough at best, is thereby greatly diminished.
It is our considered view that the nation’s interest would be served by amending the Securities Act so as to prohibit the public offering of securities of new and definitely unseasoned ventures. It would not be easy to define precisely the criteria of “seasoning,”—
e.g.
, size, number of years’ operation without loss—and it may be necessary to vest some discretion on this score with the S.E.C. We think, however, that borderline and difficult cases will be relatively few in number (although our second example above belongs, perhaps, in this category). We should be glad to see the powers and duties of the S.E.C. diminished in many details of minor significance; but on this point of protecting a public incapable of protecting itself, our view leans strongly towards more drastic legislation.
Blue-sky Promotions. In the “good old days” fraudulent stock promoters relied so largely upon high pressure salesmanship that they
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